Economics: crawling from the wreckage?

Padraic Finn

A review of Joe Earle, Cahal Moran and Zach Ward-Perkins, The Econocracy: The Perils of Leaving Economics to the Experts (Manchester University Press, 2017), £9.99.

Opening a new building at the London School of Economics in November 2008, the Queen asked why nobody had seen the 2007 economic crash coming. Realising that a professorial answer—“At every stage, someone was relying on somebody else and everyone thought they were doing the right thing”—wasn’t good enough, even for a relic of feudalism (who lost 25 percent of the value of her own investments), leading economists from the Treasury, Goldman Sachs and the media convened a seminar at the Royal Society in June 2009 to attempt a better one.

After a day’s deliberations, they wrote a letter of explanation to the Queen, including by way of conclusion, “while it had many causes, [the failure to foresee the crash] was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole”. Her Maj was probably no wiser—or amused.

The authors of The Econocracy are students at the University of Manchester and “active members” of Rethinking Economics, an international student movement which aims to “reform” economics. They are very critical of the limitations of the dominant neo-classical theory (and its political child, neoliberalism) in explaining (or, as their research reveals, mostly avoiding any mention of) the crash and their book is a detailed critique of neo-classical orthodoxy in theory and method.

Noting that the older universities are more likely to offer economics courses, they call for a “rediscovery of liberal education” and criticise the syllabus of university courses for the “narrowed down” scope of neo-classical fundamentals on offer: “individualism, optimisation and equilibrium”. The core assumption of neo-classical economics is that rational individuals, the original “homo economicus”, “optimise their utility” in buying decisions or in the amount of time they devote to work—“disutility”. Such atomised decisions, including in labour markets, are then mysteriously marshalled into market equilibrium by Adam Smith’s “invisible hand”.

But the authors point out that Smith, recognising the centrifugal social consequences of “everyone for himself”, believed that these “laws” of price, supply and demand “held society together”. Smith’s concern about the effects of the “market” was shared by all of the great political economists including Karl Marx, David Ricardo and John Stuart Mill. But this pluralism in economics did not survive the so-called marginalist revolution of the late 19th century, which attempted to give the subject a “scientific” underpinning, with an increased use of maths and a focus on the measurable behaviour of individuals. This “neo-classical” approach came under critical scrutiny when it could not account for the crash of 1929. Therefore, for the next 50 years, the dominant school was Keynesian. In this context, US economist Paul Samuelson became hugely influential with his 1948 “neo-Keynesian” textbook, which combined a focus on the “macro” economy with a strong emphasis on statistics.

The neo-classical approach again came to the fore when Keynesianism seemed to be discredited by the stagflation of the 1970s. Students are now only exposed to this one perspective because, since 1986, the Research Assessment Exercise (later, Research Excellence Framework), which quantifies the research carried out by universities has “cleansed economics departments who don’t follow the neo-classical research agenda”. Clearly the political and institutional pressure supporting the orthodoxy make it difficult to achieve the pluralism the authors of this book seek.

Increasingly dominant within the orthodoxy, econometrics has all the appearance of scientific rigour, though as the authors point out, it sits atop questionable assumptions about how individuals behave. This theoretical gap may have led to the growth of behavioural economics, for which economist Richard Thaler won a Nobel Prize in 2017. In contrast to the “rational individualist” approach of neo-classical economics, research by Daniel Kahneman and others reveals that consumers are “irrational” and that decision-making is subject to “distortions” such as emotions. Behavioural economics seeks to reground the orthodoxy by focusing on actual decision-making by individuals, rather than simply pre-supposing “rationality”. However, as the authors of The Econocracy point out, the orthodoxy retains the old notion of the “rational individual” as the notional standard by which to make predictions, while consumer’s real behaviour is evaluated by the extent to which it deviates from that measure. Apart from clinging to the orthodoxy, behavioural economics is criticised for leading to very context-bound, but sometimes amusing, empirical results: for example, ascribing “utility” and “hunger” to an “agent” ordering snacks in order to calculate the price he or she would pay.

Economics “sees itself as providing neutral scientific advice on policies rather than engaging in politics directly” reducing political differences to mere “technical problems”, for example, in cost-benefit analysis. Yet in making decisions based on attaching monetary values to say, the “costs” of environmental damage, the neo-classical bias towards “growth” effectively means trading the benefit of higher current consumption against a narrow definition of the supposed benefits to future generations of protecting the environment. Similarly, though “free trade” is an article of faith among most economists, no country, not even the so-called Asian Tigers, has achieved sustained economic development without protectionism.

The authors trace the fashion for risk analysis (increasingly dominant among economists) to the creation of the Chicago Board Options Exchange in 1973. Previously banned as gambling, options trades are essentially bets on the movement of asset prices, but such speculation came to be justified by economists, who claimed it made for more efficient allocation of resources. But while exchanges exert a degree of control over markets, the increased number of “over the counter” trades, together with the banks’ use of special investment companies (usually hidden offshore), meant not only a huge ballooning of risk but very little system-level oversight of financial markets. As in other “markets” the mantra is “self-regulation”. The actual risk is only revealed by the crash.

Arguing against leaving economics to the experts, the authors believe the economy should not be simply a technical (and highly maths-based) question for the thousands of professional economists in state institutions and universities, but rather the subject of a “more inclusive” democratic debate. “Economics is for everyone” they proclaim. The Brexit vote is taken to illustrate their argument that “we live in a nation divided between a minority who feel they own the language of economics and a majority who don’t”. They suggest that better communication between these experts and the public might have led to a different outcome, although they do recognise that “social class and location were key determinants” of how people voted.

Following their belief that economics courses are too “theoretical” and removed from the real world, the authors use opinion poll-based “empirical research” to demonstrate the public’s apparent lack of understanding of “basic” questions such as who sets interest rates or the meaning of quantitative easing (QE). But this begs at least two questions: are the problems with orthodox economics reducible to a lack of public understanding? And do opinion polls (leaving aside their reliability) give much insight into the actual workings of the capitalist economy? For all the hype in the media on the doings of the high priests at the Bank of England, even orthodox economists accept that interest rates are effectively set by the private banks. Likewise, the notion that the Bank of England controls the money supply through interest rates and the related theory of “fractional reserve banking” is long discredited. The banks’ main interest in the Bank of England base rate is what they will earn on their (risk-free) deposits there.

In 2008 the Zimbabwean government ran out of paper to print its currency and its 100 trillion Zimbabwe dollar banknote became a collector’s item. Having bitterly criticised its ex-colony for profligacy, less than a year later, the Bank of England introduced QE—creating money electronically in the best modern way—to provide liquidity for its own failing banking system. Despite the injection of £435 billion since 2009, economic growth is still sluggish and low growth is forecast until the mid-2020s

The biggest impact of QE has been on asset prices: cheap cash flooded into the stock market, house prices and other assets, creating more bubbles, which some of the same “experts” now fear will burst in like manner to 2007. So, the technical explanation of QE, that it would reduce interest rates and funnel cash to the banks who would lend to businesses and thus boost the economy out of recession, was not supported by empirical studies. The main effect of QE, “improving banks’ balance sheets”, ie improving their profitability, was always its primary intention. Behind apparently technical questions, profitability always appears, though it’s almost unmentioned in the book. The “public”, beset by failing real wages, cuts in welfare and ballooning housing costs, were very unlikely to be interested in the technical details.

Despite criticisms of neo-classical orthodoxy, the authors want to reform economics, not bury it. Their reforms reduce to a request to make economics more plural and open to political debate (citizen economics) while tweaking the curriculum towards “public interest economics”. Though they recognise the intellectual collapse resulting from the crash, there is little evidence of a challenge to its fundamental assumptions. Pointing out that Keynesianism was mainly a response of the orthodoxy to the 1929 crash, they offer post-Keynesian economist Hyman Minsky’s financial instability hypothesis (crudely: bubbles happen and then they burst!) as a way of understanding what happened in 2007.

Although they question assumptions about the behaviour of “rational” ­individuals—the core premise of the orthodoxy—there is no attempt to examine whether the resultant (macro) model of the economy, built on simple aggregates of these individual (micro) decisions—and which is assumed to tend to equilibrium unless buffeted by outside shocks—is itself valid. For them, ­economics “is just the story of 7 billion people’s individual and collective choices”. Marx and markets get a mention but not capitalism, competition or profit. Crises feature only insofar as they pose technical questions for the orthodoxy.

It could be argued that misunderstanding at a systemic level is the main reason for the almost complete failure to predict the crash—or indeed to explain it other than (ironically) as “regulatory failure”, ie failure by government. Ironic in a double sense, because the financial sector (containing the most “efficient markets”) was quick to demand that governments intervene to save it from the “normal” operation of “the market”—bankruptcy.

Padraic Finn is a long-standing activist with an equally long interest in political economy.